Lost dollars are simply harder to replace than gained dollars are to lose. – Michael Burry
Loss-Regain
- The more you lose, the harder (and longer) it will take to (even) get back to where your started. As the hole grows deeper, the effort to climb out of rises, exponentially.
- Never lose Money. Never incur a “permanent loss of capital”.
- Focus on Risk first, then on Returns. “Our defense is better than our offense”.
- Ensure the ‘Return OF Capital’ prior to the ‘Return ON Capital’
- Safety First. Focus and protect the Downside first. The upside will take care of itself.
- Maximizing the upside means first and foremost minimizing the downside. The deleterious effect of permanent capital loss on portfolio returns cannot be overstated.
- Be perfectly willing to trade off a (risky) large payoff for a (riskless) certain payoff.
Consider: When planning for a double, every $1 in excess cost amounts to $2 in excess gain required. Every dollar saved(-$1) amounts to the same $2 in excess gain already realized. Say the value of an item were X. If the purchase price were X, to get a double we would need it to reach 2X. If the purchase price were X+1, the double would be 2X+2. “Every excess dollar amounts to $2 in excess gain required”. Or say if we have paid an additional 20% to value. We would need an excess gain of 40% to reach a double. Now say the purchase price were X-1. To reach a double of the value (or 2X), we would need to achieve $2 less (2X-2). Effectively we have already realized or gained $2 at purchase time. Money being made at the time of purchase.
The table above has shown that a 33.3% loss requires a 50% gain to attain breakeven. On the flip side, 33.3% saved on the buy price makes a 50% gain back to the price of first consideration. On a percentage basis – and it is on this basis that we must evaluate each and every decision – lost dollars are simply harder to replace than gained dollars are to lose.
Law of “Value Gravity”
Use the force of “Value Gravity” to your advantage. Do not resist or work against it – Kawthari
Mr Market is moody, temperamental, and an emotional wreck. At times he is elatedly optimistic and upbeat, at other times a manic depressive. His emotional states, in either direction are the equivalent of market inefficiency. When he is neither, an acting highly indifferent (the pendulum in Howard Marks’ “Happy Medium”) we observe market efficiency.
Scene 1: When Mr Market is Elated and Optimistic:
Say we begin with $1 and buy an asset whose intrinsic value (IV) is worth 50c for this $1. We would immediately incur a starter’s handicap or a beginner’s dis-advantage by doing so. We would incur an instant 50% loss on our buy-price if the market were to become instantly efficient. And when this occurs (as it inevitably would given enough time), our $1 investment would be worth 50c, a loss of 50%. We would then require a 100% gain to regain our starting position, of $1.
Risk-Reward : Furthermore, let’s assume that the 50c intrinsic value was bought for $1 in speculation and hope of making a profit when the price would rise higher. And say it does indeed. Then as the buy-price rises and diverges itself higher and further away from the IV, 2 things occur:
- First, both the possibility AND the size of the future incremental GAINS decrease. This occurs because the “rate of price-rise” becomes slower as the price rises higher and as it gets closer to its inevitable peak. A useful analogy is that of earth’s gravitational force acting on a ball thrown up in the air.
- Secondly, the possibility AND the size of total RISK increases. This occurs because the chances of the cycle reversing (and hence price falling) increases as the peak is reached. Again the “ball in the air” analogy is useful.
We can therefore conclude that 3 things occur when a ‘Buy-price > Intrinsic Value’:
- We start out with a loss.
- Both the “probability” AND the “size” of potential loss (or risk) are HIGH
- Both the “probability” AND “size” of potential gain are LOW.
Here is another analogy to elucidate the point. Think of a 2-person 100m race in which one of the runners starts out with a 10m handicap, faces hurdles along the track to clear, and is entitled to a much lower prize money if he wins. His competitor, the second runner, on the other hand starts at the start-line itself, gets to run a smooth track and on winning, is rewarded a much higher prize money. The second runner is not only more likely to win, he gets to win a bigger prize. (hardly a fair race one would say).
We define a term called ‘(Intrinsic) Value Gravity’ as a universal force that acts to pull an asset’s price towards its intrinsic value. It always exist and acts to cause the gap between the price and value to close. When “Buy-price > Intrinsic Value”, the force of IV-Gravity acts on the price in the downward direction, resulting in an economic loss to the investor. The force of market speculation and optimism may exceed gravity at times and can take the price higher for some time but ultimately gravity prevails. And once the price capitulates and falls to meet IV, it would require the investor to exert a force working against gravity for the price to rise again to its original position and overcome the prior loss. Exerting the force would demand that the investor incurs additional risk. Needless to say, that is a challenging prospect. IV-Gravity explains the phenomenon of “Regression to the Mean”.
This is illustrated in the top half of the attached chart.. Here, gravity works against the investor whereby a) it acts to cause a loss and b) once a loss is incurred ($150c), it is difficult for the price to rise again to $1. Hence, “Lost dollars are simply harder to replace.”
Scene 2: When Mr Market Depressed and Pessimistic:
Loss Regain: Now say we begin with $50c and buy an asset whose IV is worth $1. We would immediately incur a starter’s advantage. We would incur an instant 50% gain on our buy-price if the market were to become instantly efficient. And when this occurs (as it inevitably would given enough time), our 50c investment would be worth $1 resulting in a 100% gain on our starting position of 50c.
Risk:Reward : Also, say the $1 intrinsic value is bought for 50c and the price falls. Then as the buy-price falls lower and diverges further from the IV, 2 things happen:
- Both the possibility AND the size of potential future GAIN increases because the “rate of price-fall” becomes slower as the price falls lower and gets closer to the inevitable trough.
- Plus, the possibility AND the size of the incremental RISK decreases. This occurs because the chances of the cycle reversing and hence price rising increases as the trough is reached.
We therefore can conclude that 3 things occur when “Buy-price < Intrinsic Value”:
- We start out with a gain.
- We incur a low and a decreasing “probability” and “size” of loss(or risk) and
- The “probability” AND the “size” in case of a potential gain are high.
In the analogy of the 2-person 100m race, here the first runner starts out with a 10m advantage at the start-line, has a smooth track to run and wins higher prize money as compared to his handicapped competitor.
When ‘Buy-price < Intrinsic Value‘ …the force of IV-Gravity acts on the price in the upward direction, resulting in an economic gain. The force of market pessimism and negative trend extrapolators may exceed gravity and may take prices lower for some time but ultimately gravity prevails. Once the price rises to meet IV, it would require a force working against gravity for it to fall to its original position and overcome the gain, an unlikely prospect. This reduces the investor’s risk.
This is illustrated in the lower half of the attached chart. Here, gravity works for the investor whereby a) it acts to cause a gain and b) once a gain is incurred (50c$1), it is unlikely for the price to fall back to 50c. Hence, ‘Gained dollars are harder to lose.’
Urdu poetry alluding to this article’s ideas:Ik jaa girna aasaa’n, girke uth’na dushwaar,Doo-je girna mushkil, aur uth’na nihaayat aasaan – Kawthari
Vo kahin bhi gayaa lautaa to mere paas aayaa
bas yahii baat hai achchhii mere harjaa_ii kii – Parvin Shakir
Husain Kothari
January 16th, 2013
KIP Capital blog 